Everyone in the world is unique. When we at school, some of us may be good at Math, others may be interested in Geography.
In economics, it’s the same when we produce goods and deliver services. Therefore, the global market has divisions of labors.
Nowadays, we see a lot of real-life examples of market divisions. For example, the research and development of iPhones is done in the US; China, Japan and other Asian countries are main producers of iPhone parts.
Why would market divide labors like this? Why can’t Apple produce all the parts in the US? It’s related to an important concept in economic theory, comparative advantage.
Key to understanding of comparative advantage is opportunity cost. An opportunity cost is the potential benefit that someone loses if he doesn’t choose to do one thing rather than the other. In the case of comparative advantage, if the opportunity cost of the company is lower than its competitors, this company has comparative advantage.
For example, there are two factories, A and B, producing cars and bicycles. To produce 1 car, factory A needs 1 day, factory B needs 2 days. But for factory A, if it doesn’t make cars, it can produce 10 bicycles one day. For country B, it uses 2 days to produce 5 bicycles. In other words, for factory A, its opportunity cost for producing 1 car is 10 bicycles; for factory B, its opportunity cost is 5 bicycles. Therefore, factory B has comparative advantage for producing cars, because it has lower opportunity cost.
The theory of comparative advantage was first introduced in 1817 by David Ricardo. It provides a theoretical basis for free trade policy. People realized that production can be more effective through divisions and thus greatly promoted the global trade.